under control, are evident. East Asian countries generally adopt more conservative fiscal stances than Latin American countries.
Under a floating-rate regime, the additional exchange rate flexibility dampens some of these effects, but at the cost of loss of control over the nominal exchange rate. Fiscal policy becomes relatively lass effective in influencing domestic output. The increase in demand from expansion leads to an appreciation of the nominal (and, consequently, the real) exchange rate, increased imports and lower exports, and less demanded for money and bonds.
Interest rates rise, but less than in the fixed-rate case, and the floating rate keeps the external accounts in balance. The increase in capital inflows offsets the higher current account deficit. Under most reasonable assumptions, output rises, but less than under a fixed exchange rate for a given increase in expenditures. By contrast, monetary policy can have a more compelling effect. An expansionary action, such as open market purchase of domestic bonds, increases output through the effects of money supply on demand. It also leads to a depreciation, which shifts resources to the tradable sector and decreases the current account deficit, offsetting the outflow of capital brought about by the more perfect substitutability of assets, although the interest rate change will be smaller.
These models can also be used in reverse to examine the effects of a change in external variables on the domestic economy. What are the implications when we look at the effect on domestic policy of increases in foreign capital inflows? For a regime with a fixed nominal exchange rate, an increase in foreign inflows tends to reduce the domestic interest rate and increase domestic demand. This, in turn, leads to an increase in domestic prices that will bring about a real appreciation through higher domestic inflation. Reserves tend to accumulate, although by less than the capital inflows, as the current account also deteriorates. Monetary policy action to absorb the capital inflows through, for example, open-market sales of bonds (sterilized intervention) could offset the impact on demand. But such an action would tend to increase interest rates, which could well attract more capital inflow. It is not likely to be effective in the long term if there are practical limits on how many bonds can be issued, and it could be costly (because of negative carry on the reserves accumulated). The more substitutability there is between domestic and foreign assets, the less variance is possible between domestic and foreign interest rates before increase in the domestic interest rate become self-defeating. Fiscal contraction would offset the increase in demand and perhaps allow a reduction in interest rates, which would diminish the attraction of domestic assets to foreign investors. A fiscal response would take longer to orchestrate than a monetary response, however, become...
